VOLATILITY AS A MEASURE OF RISK
Learn even more about this topic with the Encyclopedia of Personal Finance™
If you are looking for large returns on your retirement
investments, you will need to accept more risk. The greater the risk, the
greater the potential rate of return.
describe risk in terms of volatility, i.e., the amount your investment
values fluctuate up and down over time.
Volatility potentially can work in your favor during the
accumulation investment phase. It becomes more of a concern when you need to
withdraw money, because it may be during a period when the markets and your
account values are down.
Historically, stocks tend to have the highest rate of return
compared to bonds and cash. Of course, they also have the greatest risk due to
their higher volatility. The longer the period of the investment, the lower the
volatility, because the long-term growth trend of a stock tends to overcome
short-term price drops. If you are close to retirement, you may want to stay
away from more volatile investments. However, if your retirement is still many
years away, it may pay to invest in these volatile markets. Let?s say you invest
a lump sum of $100,000 into a highly volatile asset returning an average annual
rate of return of 10 percent over 25 years. The year you retire, it suddenly
drops by 25 percent. The value of your investment after the drop is $813,000. If
you had invested that same $100,000 lump sum into a less volatile investment
with a 6 percent return and experienced no 25 percent loss in the final year,
you would still only have $429,000 after 25 years. So even with a significant
loss, it paid to invest in the more volatile investment.
Now that you understand some of the risks involved in
retirement investing, you need to decide what assets you will invest